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• Conversion
• Reverse Conversion
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• Converting between domestic and foreign currency options:
• Bid-Ask Prices
• American Options:
(S) − Ke−rT , S0 − K
P
– Calls: S ≥ CA ≥ CE ≥ max 0, F0,T
– Puts: K ≥ PA ≥ PE ≥ max 0, Ke−rT − F0,T
P
(S), K − S0
– Calls:
∗ lose the implicit Put
∗ if non-dividend then CA = CE
∗ not rational if P Vt,T (Div) < K(1 − e−r(T −t) ) + P
· b/c you get stock and Divs. but pay K and lose the im-
plicit Put
– Puts:
∗ lose the implicit Call
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∗ may be rationa even if no dividends
∗ earn interest on K
– Direction:
∗ C1 ≤ C2 and P1 ≤ P2
∂C ∂P
∗ ∂K ≤ 0 and ∂K ≥0
– Slope:
∗ C1 − C2 ≥ K2 − K1 and P1 − P2 ≤ K1 − K2
∂C ∂P
∗ ∂K ≥ −1 and ∂K ≤1
– Convexity:
C1 −C2 C2 −C3 −P2 P2 −P3
∗ K1 −K2
≥ K2 −K3
and KP11 −K 2
≥ K2 −K3
∂2C ∂2P
∗ ∂K 2
≥ 0 and ∂K 2 ≤ 0
· K1 > K2 > K3
• Strike Price Increases Over Time on a Call - suppose that a stock does
not pay dividends and the strike price increases at a rate that is less than
or equal to r:
KT ≤ Kt er(T −t)
The longer the call option, the more valuable it is:
C(S0 , KT , T ) ≥ C(S0 , Kt , t) for T > t
If the inequality above is violated, then arbitrage is available.
That is if:
KT ≤ Kt er(T −t) and C(S0 , KT , T ) < C(S0 , K, T )
then arbitrage can be obtained with the following steps:
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• Replicating Portfolio: B stands for bond, not borrowing; amount we
lend
−δh Cu −Cd
• ∆=e S(u−d)
uCd −dCu
• B = e−rh
u−d
e(r−δ)h −d
• p∗ = u−d
• C = S∆ + B
rh
P rice1 ∆1 + · · · + P ricen ∆n + Be = P ayof f1
n+1 times .. .. .. ..
. ··· . . .
P rice ∆ + · · · P rice ∆ + Berh = P ayof f
1 1 n n n
– p∗ = 1√
1+eσ h
Ft,t+h /St −d
– p∗ = u−d
= 1−d
u−d
Cu −Cd
– ∆= F (u−d)
uCd −dCu Cu −Cd
– B = C = e−rh
u−d
+ u−d
4
• Seαh = puSeδh + (1 − p)dSeδh
e(α−δ)h −d
– ⇒p= u−d
S∆ B
• eγh = S∆+B
eαh + S∆+B
erh
• Important Formulas:
– QH = pUH QL = (1 − p)UL
1
– QH + QL = 1+r
– C0 = pUH CH + (1 − p)CL QL = QH CH + QL CL
pCH +(1−p)CL pCH +(1−p)CL pCH +(1−p)CL
– 1+α= C0
= pUH CH +(1−p)UL CL
= QH CH +QL CL
pUH QH
– p∗ = pUH +(1−p)CL
= QH +QL
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p∗ UL
∗ ⇒ solve for p ⇒ p = p∗ UL +(1−p∗ )UH
• Estimating Volatility
r
√ n
P
x2i
– σ̂ = p n−1 n
− x̄2
St
– use ln St−1
for data points
• Properties
1 2
– E(Y ) = em+ 2 v
2m+v2 v2
– V (Y ) = e e −1
6
2
– mode = em−v
∗ m = µt = α − δ − 21 σ 2 t
√
∗ v=σ t
• Lognormal Confidence Intervals: Assume that the stock prices are log-
normally
distributed:
ln SSTt ∼ N (α − δ − 12 σ 2 )(T − t), σ 2 (T − t)
T >t
The (1 − p) confidence interval is:
P r STL < ST < STU = 1 − p
The lower and upper stock prices defining the confidence interval are:
1 2 )(T −t)+|σ L |
√
T −t
– STL = St e(α−δ− 2 σ Z
1 2 )(T −t)+|σ U |
√
T −t
– STU = St e(α−δ− 2 σ Z
– E(X 2 ) ≥ (E(X))2
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• Expected Payoff
• Expected Value
1 2
– E[ST |S0 ] = S0 e(µ+ 2 σ )t
St
• Estimate using ln St−1
as data points
• Annual Return: α̂ = µ̂ + 12 σ̂ 2
8
• The futures period affects the forward price of the stock but does not
affect the option price in any other way
• ∆C − ∆P = e−δt
– ∆C = e−δt N (d1 )
– S-shaped
• ΓC = ΓP
• V egaC = V egaP
• Ct − Pt = −δSe−δt + rKe−rt
1 δSe−δt −rKe−rt
– Θ = − 365 Ct ⇒ ΘC − ΘP = 365
– Upside-down hump; almost always < 0 unless far in the money
• ρC − ρP = .01tKe−rt
• ΨC − ΨP = −.01tSe−δt
∆/C S∆
– Ω= /S
= C
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γ−r Ω(α−r) α−r
– γ − r = Ω(α − r) ⇒ σoption
= Ωσstock
= σstock
• Volatility
10
• Overnight Profit on a Delta-Hedged Portfolio
r
– Profit = −(C1 − C0 ) + ∆(S1 − S0 ) − (e 365 − 1)(∆S0 − C0 )
• Delta-gamma-theta approximation
– C1 = C0 + ∆ + 12 Γ2 + θh
∗ = Sh − S0
• Black-Scholes Equation
– rC = S∆(r − δ) + 12 ΓS 2 σ 2 + θh
• Reheding
• Misc. Notes
11
– Sell Put ⇒ Sell Stock
• Compound Options
– CoC − P oC = C − x0 e−rt1
– CoP − P oP = P − x0 e−rt1
• All-or-nothing Options
• Gap Options
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– Remember that ST > trigger for Calls and ST < trigger for Puts
– Put-Call Parity applies
– If two otherwise identical gap options have different strike prices,
then use linear interpolation to find the price of a third otherwise
identical gap option with a different strike price.
• Exchange Options
• Chooser Options
– Derivation
13
• Use r to discount when pricing options
– Importance Sampling
• Random Walk
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1. X(0) = 0
1
k + 1, with p =
2. For t > 0, if X(t − 1) = k, then X(t) = 2
1
k − 1, with p = 2
3. Memoryless.
5. X(t) ∼ Bin t, 12
• Brownian Motion
√
– Move h per h units of time and take limh→0
– Properties
1. Z(0) = 0
2. Z(t + s)|Z(t) ∼ N (Z(t), s)
3. Z(t + s1 ) − Z(t) is independent of Z(t) − Z(t − s2 )
4. Z(t) is cont. in t
∗ E[Z(t)] = 0
∗ E[Z(t + h)|Z(t)] = Z(t)
∗ E[Z(t + h) − Z(t)] = 0
∗ E[dZ(t)] = 0
∗ E[dZ(t)|Z(t)] = 0
∗ E [(Z(t))2 ] = t
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∗ E [(dZ(t))2 ] = dt
∗ E[Z(t)Z(s)] = M in(t, s)
∗ V [Z(t)] = t
∗ V [Z(t + h)|Z(t)] = h
∗ V [Z(t + h) − Z(t)] = h
∗ V [dZ(t)] = dt
∗ V [dZ(t)|Z(t)] = dt
∗ ABM and GBM are martingales iff they have zero drift
– X(t) = αt + σZ(t)
1 2 )t
∗ Mean = e(µ+ 2 σ
2 2
∗ Variance = e(2µ+σ )t (eσ t − 1)
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P
• V ar(ln(S(t))|S(0)) = V ar(ln(F0,T (S))) = V ar(ln(F0,T (S)))
• Forms of BM
dS
– GBM: S
= (α − δ)dt + σdZ
• When you add δ to total return (for Sharpe Ratio), only add to S, not
C
• dC = CS dS + 12 CSS (dS)2 + Ct dt
– rC = S∆(r − δ) + 12 ΓS 2 σ 2 + θh
α−r
– φ= σ
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– For 2 Itô processes with the same dZ, the Sharpe Ratios are equal
• Problems which give 2 processes, Prices and ask how much should be
allocated to each process. Such as:
dS1 dS2
1. S1
= α1 dt + σ1 dZ and S2
= α2 dt + σ2 dZ
αi −r αM −r
• CAPM: σi
= ρi,M σM
– φi = ρi,M φM
• Risk-Neutral Processes
∗ dZ̃ = dZ + ηdt
α−r
· where η = σ
∗ E ∗ [Z̃(T )] = 0
∗ E ∗ [Z(T )] = r−α
σ
T
∗ E[Z(T )] = 0
α−r
∗ E[Z̃(T )] = σ
T
• Valuing a Forward on S a
1 2 a(a−1)]T
– E[S(T )a ] = S0a e[a(α−δ)+ 2 σ
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1 2 a(a−1)]T
– F0,T (S a ) = S0a e[a(r−δ)+ 2 σ
P
– F0,T (S a ) = e−rT · F0,T (S a )
dS
– If C = S a and S
= (α − δ)dt + σdZ then
1
∗ dC
C
= (a(α − δ) + σ 2 a(a − 1) + δ ∗ ) dt + σadZ
| 2 {z }
γ
· ⇒ γ = a(α − r) + r
• Stochastic Integration
• Ornstein-Uhlenbeck Process
• Misc. Notes
19
– volatility of S n is n · σ (remember when working with Black-
Scholes)
P (t,T +s)
– Ft,T (P (T, T + s)) = P (t,T )
• Binomial Trees
1
– Bond Price = (1+R)n
1 Ru
2
ln Rd
– σ= √
h
2 year Bond Price 1 1 1
– 1 year Bond Price
= 2 1+R1
+ 1+R1 e2σ
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– Discount difference due to cap by the discount rate appropriate
to the beginning of the year
T −KR
– Cap pays max 0, R1+R T
– For multiple year trees, start @ end and calculate the value then
weigh the results and add in the additional cap values as you
move to t0
F
ln( K )√+ 12 σ2 T √
– where d1 = σ T
and d2 = d1 − σ T
1
– (1 + KR ) Puts with strike price 1+KR
– Calculate @ each node and then add together and multiply the
sum by (1 + KR )
dP
– dr = a(r)dt + σ(r)dZ and P
= α(r, t, T )dt − q(r, t, T )dZ
· q(r, t, T ) = P1 Pr σ(r)
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• Black-Scholes equation for Bonds
– Z̃(t) = Z(t) − φ
– dr = ardt + σrdZ
– a 6= 0
22
2 σ2
∗ A(t, T ) = er̄[B−(T −t)]−B 4a
1−e−a(T −t)
∗ B(t, T ) = a
φ 1 σ 2
∗ r̄ = b + σa − 2 a
– a=0
3
1 2 +σ 2 (T −t)
∗ A(t, T ) = e 2 σφ(T −t) 6
∗ B(t, T ) = T − t
– ∆ = Pr = −BP
– Γ = Prr = B 2 P
– φσ = φ̄r
p
∗ where γ = (a − φ̄)2 + 2σ̄ 2
• Misc. Notes
23
– Vasicek
• Delta Hedging
• Delta-Gamma-Theta Approximation
– P (r + , 0, t + h) = P (r, 0, t) + ∆ + 12 Γ2 + θh
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